TTU125: Michael Pomada, President and CEO of Crabel Capital Management

[00:00:00] Michael

Everyone likes easy, right? Think about America today, by the way. There’s a drug for every problem. You have high blood pressure? I got a drug for you. You have high cholesterol? I got a drug for you. You’re obese? I have a drug for you. It’s that thing where maybe instead of giving you a drug, you should exercise and eat better. Imagine that.

So when I think about this, I’m not saying it’s dumb, but it seems like a drug answer to a problem. Whereas I think for those of us who work in the space, short-term, medium-term, long-term, we’re really trying to make the portfolios better.

[00:00:41] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:36] Niels

Hey everyone, and welcome to another edition of Top Traders Unplugged, where Alan Dunne and I today are joined by Michael Pomada, President and CEO at Crabel Capital Management, as part of our mini-series focusing on the one investment strategy that beat everything else in 2022, namely trend following and managed futures more broadly.

First off, Michael, it is great to have you on the podcast. Thanks so much for joining us today. We really have been looking forward to our conversation. How are you doing? How are things in LA at the start of the new year?

[00:02:07] Michael

I love the start of the new year because it’s almost like a rebirth. All the mistakes that we made last year, all the things that we did wrong, they’re all in the past. There’s only a perfect year ahead of us.

[00:02:18] Niels

Absolutely. Fantastic. Well, we have some different topics lined up and we’ll go back and forth between ourselves here. But before we dive into all of that, maybe, for the audience’s benefit, we can set the stage for our conversation and ask you to talk a little bit about your firm’s background and also the highlights in terms of the strategies you run and also where the business stands as we head into 2023.

[00:02:45] Michael

Sure. I think Crabel is most well-known for its founder, Toby Crabel, and doing short-term diversified quantitative strategies in the futures and FX space. Currently, we manage about $8.2 billion and that’s been growing over the last few years as interest in uncorrelated strategies has become more and more important to pension funds, portfolios – there has been more and more interest, which has been great, obviously. Yeah, but mostly we’re known for short-term, but all the way out the spectrum, so from minutes to hours, all the way out to months and years for our trend follower.

[00:03:24] Niels

I thought you were going to respond that you are most known for Toby’s white suits that he was wearing to the conferences back in the ’90s and the early 2000s.

[00:03:34] Michael

Toby is an amazing dresser if anyone doesn’t know that, and he definitely thinks about it.

[00:03:40] Niels

Absolutely, indeed. Well, as usual, Alan, why don’t I kick it over to you to dive into the first real topic of today?

[00:03:48] Alan

Good stuff. Well, great. Michael, you mentioned how you’re well-known for short-term quant strategies. If you were to sum up what’s the philosophy behind your approach to being involved in markets, how would you describe that?

[00:04:02] Michael

I think relative to some quant strategies out there, we tend to be observationally based or behaviorally based. A lot of the strategies that have been developed over the years, from Toby’s original strategies, to the ones we even develop today are really about observing the markets, understanding the situations, and then trying to come up with a hypothesis about why the markets might move in a certain way, why the participants might react in a certain way to a certain situation, and then taking advantage of those anomalies.

[00:04:32] Alan

Interesting. I see over your shoulder there you have a copy of something I wanted to bring up. Toby also, apart from the white suits, is probably very well-known from the book he wrote: Day Trading With Short-Term Price Patterns and Opening Range Breakouts. It’s interesting as you go around a circuit meeting, short-term managers and a lot of people reference that book.

Obviously, it was probably written back in the late ’80s I think. How relevant is that still today? Is that type of trading still the underpinning of a lot of his strategies? Can you comment on that?

[00:05:06] Michael

Sure, of course. Two things. Number one, there’s a funny story about this book that’s behind me. I bought it myself for $1,000 online.

[00:05:17] Alan

I went looking for one and the cheapest I can see here is €1126, so you got a deal then.

[00:05:24] Michael

Yeah. I made money, another good trade. But here’s the funny part. I told Toby, I said, “Toby, I bought your book. I paid $1,000 for it.” He said, “What in the world are you doing? Why would you do that?” I said, “Toby, I’m going to have you sign it. This thing’s going to be worth like two grand. That’s an instant profit.” He’s like, “We need to split that.” I was like, “Okay, no problem.”

No, it’s a great question and the truth is that (for those who don’t know Toby), he is a keen market observer and a lot of the observations that he’s made back in the olden days, the good old days as we like to say, but even today are really poignant. If you’re asking me the question of whether or not the concepts that he’s written about, in his book, are still relevant today? Absolutely. Crabel does take advantage of a lot of the concepts that are there. They’ve advanced over the years, I’m not going lie. It’s not like we’re running the strategies that are in the book.

But the reality is that the concepts of market participant behaviors, that create anomalies in the marketplace you can take advantage of, are (a lot of times in observation) like he did in his book. He still does that today. He’s the keenest market observer I know. It’s an honor to work with him and, as my mentor, I can say I learn something from him every day.

[00:06:35] Alan

Coincidentally, the other book you have, over your left shoulder that I can see (obviously the listeners don’t have the benefit of this), is Victor Niederhoffer’s book The Education of a Speculator, which is another one of my favorites. Obviously, Toby Crabel spent time working with Victor. Victor had that short-term, behavioral-based, but also very much kind of a latticework-type approach of finding inspiration in lots of different places. Is that something that you guys buy into as well?

[00:07:06] Michael

We have something like eight people at the firm who worked at Victor Niederhoffer’s shop, including myself. It was a joy and all of us really learned a great deal from working with Victor. He was probably the most eclectic thinker about markets(maybe still is), the most eclectic thinker about markets that I know.

I’d say we’re a little more narrowly focused. We tend to be more behaviorally based, a little more in tune with the markets. Victor, I felt like, thought about lots of different things from ecology to physics, whereas we tend to be a little more focused on the actual movements in the marketplace. That being said, I think about the thing that Toby did for the industry. Really, if you look back 30 years ago when the firm was founded, one of the big things about Victor was that he was so eclectic and amazing at understanding behaviors and finding anomalies.

Finding anomalies is hard, by the way. Finding anomalies is hard. But one thing that Toby did, that was really something that Victor could never quite get his head around (no offense to Victor, of course, I still love him), was on the risk management side. I know we’re going to talk about it a little bit later, but it’s the thing.

We have a bit of a saying inside of Crabel and it’s a Toby saying. I recently spoke about it at our holiday party, which is, “Live to fight another day,” or “Keep the drawdowns small, and the upside will take care of itself.” It’s something that we really think a lot about at Crabel. It’s one thing to be a great eclectic thinker about anomalies and it’s quite another to be able to exploit those anomalies in the marketplace and do it in a risk-adjusted fashion that’s palatable to pension funds and other large investors that are looking for an interesting return stream.

[00:08:46] Alan

Okay, interesting. Yeah. Bringing it back into the context of managed futures, you touched on being very short-term and diversifying strategies. Would you say your focus is purely on generating absolute return or is it absolute return plus some kind of crisis alpha? Are you specifically targeting a correlation to equity or is that an offshoot of your strategy? How do you think about all of that in terms of program objectives?

[00:09:14] Michael

Interesting question. I think there are a couple of things. Number one, what is true about our short-term trading is that, over the years, it is not by design that we’re zero correlated to stocks. We do have a program that is negatively correlated to the stock market, where we use our alpha to try to beat the S&P and also, obviously, trade a lot of different markets to get diversification and that product has been relatively successful for us.

But the truth is that one aspect of our trading (and this is an aspect of all managed futures, a lot of managed futures, if you think about what role do we play in the client’s portfolios), part of that is being long vol most of the time. I know there’s an argument about being long vol in trend following, it’s not always long vol. We know that.

If you look at January, February 2018, you had the big up in January, and then a big giveback in February. That’s a market sell-off, therefore you were (in that case) long stocks and short vol. But the truth is that the majority of the strategies in our space (which I think is one of the coolest benefits of our space), is that we’re mostly long vol and no, it’s not by design.

One thing I would say (particularly on the shorter end), think 20 days and below or something like that in terms of holding period; or even adapting to a situation; think March 2020. All the trend followers had a great March 2020. We happened to have a very good March 2020. Very adaptive, right? That’s part of the design of the program. But the reality is that being long vol oftentimes means making money when the stock market goes down because oftentimes the vol is more explosive there.

I’m not saying we’re not going to make money when stocks go up. I mean, you can look at our long track record to see that that’s not the case. But the reality is that the marketplace oftentimes makes a lot of mistakes when the market is falling rather than going up. So I think it gives all of us that little bit of interesting diversifying aspects of the portfolio that are very cool for institutional investor’s portfolios or anyone’s portfolios for that matter, including my own. Who doesn’t love it?

[00:11:19] Alan

Niels?

[00:11:20] Niels

Yeah. I was just going to pick up on some of these points. Now, as you already mentioned, you run different types of strategies: some short term, some are more in the trend following space. But actually, I think this is relevant for all of them, in some sense. It’s based a little bit on a paper that Cliff Asness came out with last year where he’s basically saying – I think he’s raising the question, are we becoming too concerned about the Sharpe – essentially, making choices that may look good in the short term but actually are detracting from our long-term performance. So, I’d love to hear your thoughts about that whole topic.

[00:12:04] Michael

It’s an interesting problem because if you think about what happens in the industry, and this has been true forever I think, but there’s, oftentimes, a little bit of performance chasing. So, if a concept, like trend following or maybe a middle term that’s not trend following that has alpha, maybe it has a period of time where the markets aren’t as fruitful for those types of strategies, and then people will say, “Oh, this is disappointing.” Look at 2021 as an example. You had stock trade up that year and everybody made money in bonds too, and real estate and private equity, which always makes money, right? Don’t you guys know? There was a great Cliff Asness piece, actually.

[00:12:43] Niels

That’s his next paper, by the way, about private equity.

[00:12:47] Michael

I did. There was a great piece actually, this morning I think, or maybe it was yesterday or last week that came out about private equity never has to mark to markets. So, what’s going on with that? Does that make sense?

The thing that people need to step back and really consider (and you guys know this as much as anyone in the world), which is, what’s the best portfolio going to be for the next 10 years? Not next week, not tomorrow. not “Did we catch this down move on CPI day in September right or wrong?” That’s a little bit of a noise because the truth is, we’re not talking about Sharpe ratios that are a 5 here. It’s not like we’re going to make money every single day. The truth is you’re looking for anomalies that persist over long periods of time.

Now, I’m not saying you should stick around with people who lose lots and lots of money, year after year after year, just because you hope one day, they’re going to make you money in a tail hedged fashion. Nassim Taleb has been talking about this for years. Victor, he always warred about this particular topic. But the reality is, if you can get a positive drift with some kind of interesting diversifying return stream, you should be thinking long-term, not short-term.

So therefore, if there’s a period of time where trend following or our strategies happen to underperform by a little bit, I think you have to understand the long-term effects of that. Now look, if you believe the anomaly has gone away and you believe they’re not possible, okay, I understand but I don’t agree with you. The reality is that if you believe that it’s there, and you believe in the manager you’ve chosen to execute that strategy, no matter who it is (and there are a lot of great ones in our space), then I think you have to really think big picture, longer term and think about the construction of your portfolio in every different market environment, not when the S&P goes up every single day.

[00:14:27] Niels

You mentioned something important there, namely construction of your portfolio. Let’s bring that back to Sharpe. As far as I remember, Sharpe was never invented to be used on a single strategy. It was used for a portfolio, yet we use it on single strategies today. Is there, in your opinion, a better stat or matrix that people should think about when they look at our space, maybe specifically rather than Sharpe?

[00:14:55] Michael

Great question. I think Sharpe can fool you. For those of us who have worked in this business for a bit, you know that you can have a 2 Sharpe, 3 Sharpe forever until it blows up. And it’s like, oh, wow, I’m making money in the basis trade every single day until mid-March of 2020. Hey look, basis trade players out there got a little lucky with the Fed because they were on the border of really having some steep losses.

So for me, that’s a great example of where the backtest is going to look perfect. The realized returns have been pretty good, right guys? I mean, come on! The basis trade works. It’s a concept that’s not horrible. Any kind of carry where there’s a drift in your favor, yeah, we know about that. But we also know it has these pitfalls and I think that’s where it gets really tricky when you’re looking at backtests of strategies or short vol in particular.

In general, you really need to be thinking about how should this portfolio behave in different types of market environments? Is it going to get every one of them right? Probably not. But is it going to get the preponderance of them right and is it going to protect you a little bit against that downside? In other words, when it gets it wrong, is it going to lose all your money? Is that what we’re talking about here? Are we talking about a strategy that is going to have a small drawdown that it will likely get out of?

When you look back across the last 30 years, some of the people that you interviewed on this program (obviously, we’ve been around for over 30 years), they’ve been around for longer than that. So I think that’s the way you have to think about it, rather than thinking about what’s the exact measure to get right. I think you really have to think about what are they trying to do? What are they taking advantage of? How do we expect it to act in these types of situations? Does that portfolio manager program deliver on what they’re saying it’s going to do?

[00:16:43] Niels

Alan, let’s dive into one of your favorite topics.

[00:16:46] Alan

Yeah, sure. You touched on how hard it is to unearth anomalies, so the whole research process. You said at the outset, your strategies tend to be more observationally based around behaviors. Give us a sense on how you unearth that. Has it become more difficult? I’m thinking if you go back to when maybe Toby Crabel wrote that book the first time, you were able to observe the traders a lot more readily.

We used to work on trading floors and banks or people were involved in the pitch at the exchange, and you could physically see or observe the behavioral biases – the fear, the greed, the market reactions. Now so much of the trading is obviously quant-driven, it’s in hedge funds, so there’s not the centralized areas. So does that make that kind of observational behavioral focus more difficult? What’s your process for unearthing these anomalies?

[00:17:49] Michael

You can kind of think of it as almost being circular in the following way. Back in the olden days, maybe it was more easily observed. But you didn’t have as much data and you didn’t have the types of tools we have today to really look hard for the alphas. So if you were to ask me this question, “Do you think alphas degrade through time?” The answer is obviously, yes. They have to degrade through time at some pace.

I think though, in the end, given the tools we have today and the additional datasets we have today, I think probably while easy ideas aren’t quite as easy as they were a long time ago, being able to isolate a core idea, a core anomaly that exists in the marketplace is almost easier today. Furthermore, today we have a lot more data at our fingertips. I’m talking about book data, I’m talking about spread data. We can go all the way down to the microstructure to really think about what we’re trying to take advantage of here.

For instance, if you think about predicting flows, which is distinctly something we do, we really want to say, “Oh, my goodness, someone is buying a lot and that’s likely to persist.” Now, it could be for various reasons: risk purposes, people are scared, people are greedy. There are lots of different reasons why people might be interacting in the marketplace and there might be an anomaly related to it.

But these days, you can get all the way down to that granular level and each piece of the data tells you a little story about what’s going on with those participants. So, I think from my perspective, if you ask me, and this is a funny question, if you ask me this funny question, you say, “Michael, what was your most productive year in research because anomaly has been going away? Look at all these guys out there. High-frequency traders are eating away your alpha. It’s so scary. Oh, my gosh, I wish we were back in the pits again.” (Which I disagree with, by the way, we could talk about that if you want.)

My point is that today, we can be much more observant of what’s going on. Yes, you can’t be the sucker at the table with those guys. You need to be really paying attention to what’s going on with the flows. And yeah, there’s more to take advantage of. If you asked me this question, “What’s our most productive year of research in Crabel Capital Management’s history?” [I would answer] 2022. That was our most productive year in our history. Think about our long history of making money. We’ve done amazing work over the years. We got lucky, some good work, thoughtful work. 2022 was our best year.

[00:20:08] Alan

In terms of research, yeah.

[00:20:09] Michael

In terms of research about uncovering alphas, understanding markets.

[00:20:14] Alan

Why do you think that was the case?

[00:20:20] Michael

That’s a good question. More new data, I think for us, is one piece, but just continued to observe the markets. Marketplaces change over time, the participants change over time. We just already talked about a big shift there – the pits to electronification, now high-frequency traders. Things change and so you have to be constantly observing. So it just happened to be a year where I think we picked up on a number of different concepts that were relevant to our style of trading.

[00:20:49] Alan

When you’re talking about picking up and observing, is that literally four or five key portfolio managers watching the screens all day long? What does that look like?

[00:20:59] Michael

It could be a couple of things. It’s kind of funny. I think we may be a little bit different than other people when I answer this question, mostly because we do think a little bit more in the short term, even if we apply the concepts in the longer term as well, which is something like the following. When we lose money, whenever we lose (we’re a very competitive group, by the way – at Crabel Capital Management, we’re extremely competitive), we believe in continuous improvement.

We really want the strategy to get better every single day. It really does start with Toby. He has this thing where it’s like, “No, no, I don’t care if I put this strategy in back in 1992 and it’s a sacred cow.” No, no, that’s not the way he thinks about the markets. He thinks, “Let’s make this strategy better. Let’s find another better version of it. Let’s expand it. Let’s go shorter with it. Let’s go longer with it. Let’s really extract the alpha that’s there.” So I love that about him. It’s a thought that permeates our worldview.

We are a de-siloed firm. So we don’t have a lot of individual PMs working on individual portfolios. We de-siloed the firm a number of years ago. It was a big change for Crabel. I came into the firm in 2008 as a portfolio manager, a siloed portfolio manager. But you know, the reality of the markets is they are a lot harder. In terms of going in and extracting the alpha, finding the ideas, it’s hard. It’s not easy.

What we found was that the siloed version of our firm was less efficient at exploiting the alphas that were available in the most appropriate way. So, we actually had to de-silo and expand the team a little bit to make sure the idea proliferation and implementation (that’s important, I can tell you a funny story there if you’d like), and make sure the implementation was the thing that captured the most alpha for our clients. At the end of the day, that’s the most important thing. I think it’s been a magical experience from our perspective. Again, we just had our best year in research ever and a lot of it is from being de-siloed.

[00:22:49] Alan

Okay. You mentioned idea generation, proliferation, implementation. It’s kind of like a creative process really. How do you get the right culture? How do you get the right operational setup in place? Okay, de-siloing, it sounds like one thing. Presumably, incentives are important for people. But to get those insights, is there anything operationally you can do to put in place to get a better environment for all of that?

[00:23:21] Michael

Well, I think, it starts with (obviously you know this), it starts with the team – the people. Our team, our research team, is amazing. It’s very competitive. We have a saying (again, I don’t think I can use our exact phrasing), but for those at Crabel that are listening to this, they’ll know. But it’s personal accountability. Here’s the sanitized version of the saying that we have, which is, “When we lose money tomorrow, whose fault is it?” The answer is, it’s my fault (and you can throw an expletive right in the middle of that). Which is that every researcher has to walk in feeling personal responsibility for the P&L that’s occurring in the portfolio today.

Yes, I recognize it may not be their strategy or their alpha idea that’s losing money. But the reality is, you have to walk in feeling like it’s yours. It’s not somebody else’s problem that’s sitting in this other special room over here. It’s not these other guys or these other girls over here. No, no. It’s yours. If there’s a problem with the portfolio, we made mistakes today, we lost money, we clearly made mistakes, you know what? Go figure it out. It’s not somebody else’s problem. It’s your problem. That’s a big mantra for us is to really emphasize personal responsibility or personal accountability for our P&L on a daily basis.

People talk about the siloed approach versus the de-siloed approach. (I want to tell this anecdotally just for a second. It’s kind of funny.) Look, siloed, you get perfect orthogonal concepts coming out of each. They don’t talk to each other so each portfolio group comes up with the ideas. Well, let me tell you what happens at the portfolio level when you have siloed PMs (This is just from personal experience at Crabel Capital Management.)

What happens is each siloed PM has the following three attributes of their portfolio. One, they find stuff that Toby already found. The truth is Toby is amazing so, it’s not surprising that would be the case. But yeah, you find ideas that Toby’s already found. Okay, so we have those ideas. Two, they find simple ideas. What are simple ideas? Well, you might put trend following in there. Okay, good idea because that’s a great alpha concept that’s worked for a long, long time. So, there’s trend following. Oh, wait, here’s another one: buy the dip. Buy the dip – my favorite.

By the way, if you use machine learning for research, which we do, if you use pure machine learning and give it a data set and then say, “Go find me a strategy that works,” buy the dip is the strategy it comes up with every time. Miraculously, buy the dip works. I can’t believe it. But the thing is that in the simple ideas category, you get a bunch of “buy the dip” and other (what I would think of as) basic concepts. The third part of their portfolio is amazing – orthogonal, interesting, uncorrelated alpha.

Now, let’s say you have six PMs that are siloed in that way. What do you get when you aggregate that portfolio without de-siloing them? Well, you get over-allocation to Toby ideas, you get over-allocation to simple ideas, and under-allocation to the orthogonal, interesting new ideas. So you end up with an inefficient portfolio, from the standpoint of the best realized returns for the clients.

So when we de-siloed, it was immediately obvious that we needed to down-allocate some of the simpler ideas, down-allocate some things where we were already doing the trades, and then really exploit the orthogonal ideas. That’s been super helpful for our Sharpe ratio, frankly. I feel like that was off track but I feel I had to tell that story at the very minimum.

[00:26:34] Alan

Just a couple of final ones on the whole research bit. One, you touched on machine learning. Going back to maybe three, four years ago, machine learning, everybody was putting it forward as the next greatest thing. It kind of comes and goes in the market as a great hope. Obviously, you referenced how you use it, so I’m curious to get a sense in what way you use it. The second area, for short-term managers, there’s a lot of talk about the importance of execution and how you enhance your execution capabilities. So I’m curious to hear the kind of work you’ve done on that as I know it has been a focus for your firm.

[00:27:16] Michael

Yeah, appreciate that. Machine learning, you’re right. It’s like a fad. Every year, there’s a new machine learning portfolio and it has a magical unicorn, it’s going to make money every single day forever. Two or three years later (think Teza) somehow they’re no longer running that strategy. The truth is, we’ve tried using machine learning, what I would call pure machine learning. Machine learning technique, data, mix them together, magical unicorn.

If you asked me about the 10 years that we’ve been doing that, I’m going to tell you right now, we’ve had limited success. It’s hard to admit that. We’ve tried a bunch, let me tell you. All those inroads, while they’ve not produced a negative return for us, they haven’t produced the kind of consistent persistent Sharpe ratio and return stream that you need to have to be in business. So I’d say it’s disappointing, but also a reality and I don’t think anyone’s quite solved that yet in the investment world.

Obviously, there may be someone listening today who is like, “Oh, we solved it.” Okay, you know what? Great. No problem. For us, I will tell you though, we do use it a lot. I’ll tell you how it’s a little bit different. I’m sure there are others out here that do this. But look, we have a long history of finding interesting alphas in the marketplace.

So instead of taking a machine learning process and then giving it some data and saying go, what we did – and this was done by one of our researchers, an amazing guy, such a pleasure and honor to work with him – but he said, “Hold on a second. Let me take all these alphas, stick them up here in this box and say, okay, machine learning process.” Crabel alpha is designed over the last 30 years, and every year we add more de-siloing.

Think about this just for a second. First year we ever did this, we were siloed so we only had one portfolio to draw the alphas from, and then have it produce strategies for you. So you’re going to get a Crabel flavor from the concepts that is observable money, making ideas that have a track record of success, that are real things, they’re not bullshit things, sorry. They’re not BS things in the marketplace, they’re real things that have made money through time. That process was fairly magical for us. It created a brand new set of strategies; a new set of thinking.

Sometimes it combined alphas from the early days – think of a Toby observation from the early ‘90s with an idea that came from an intern in 2012. But the thing is, those ideas had really never crossed streams before and it said, well, guess what? Instead of holding for four hours, like we wanted to in the first place, actually, that alpha is so powerful together. You want to hold that trade now for five days. That’s how powerful that alpha was together. So it was a big learning experience for us, frankly. When you first do it, obviously at Crabel, we’re cautious when we do things like this. This is a long time ago. Now, I’m telling a story that’s 8 to 10 years old.

With such good success, we’ve been able to exploit a number of anomalies that frankly we were not able to exploit before. As you know, the flagship has about $2 billion in it, Gemini has above $4 billion. Gemini uses a lot of those concepts and uses longer holds. Given that the firms generally (we had been on the shorter end), a lot of the machine learning or machine learning-assisted alphas that we created, create a big chunk of the newer strategies we run, in particular, in Gemini and Contra.

[00:30:41] Alan

Interesting. It sounds like the power of machine learning is (well, obviously), it’s the computational power of checking all of these various combinations and seeing what’s relevant in the current markets. Is that it?

[00:30:56] Michael

A hundred percent right. We redo the process, say markets change, we have new data, we have more markets, all those things go in and we are constantly basically cycling through brand new strategy creation for the firm across all of its products, including our trend follower. We really do use machine learning across the entire firm. It’s been eye-opening.

[00:31:17] Alan

The follow-up question then was around execution. Obviously, that’s been a big focus across the short-term manager’s space.

[00:31:27] Michael

First of all, we could do an entire podcast on execution. It is one of my favorite topics. I really do think it’s so important. To your point there to say something about the end of it, which is that execution isn’t cheap. It’s not cheap. The high-frequency trading guys spend hundreds of millions of dollars on this stuff. Why? Because that’s where they make all of their money. So they have to spend that kind of money.

For us guys who trade in futures that are holding a day, 10 days trend following, maybe three months, six months, maybe depending on your time, maybe even longer than that. The reality of execution is that the shorter you go, the more important it is to extract your alpha without giving away your intention to the marketplace. As soon as they figure out your intentions, they’re going to come and get you. Buyer beware.

By the way, I want to make a comment. I think this is really funny. People laugh at me and they’re like, “Oh, high-frequency trading is evil. I wish we could just go back to the pits.” No. The guys who worked in the pits (which includes Toby Crabel by the way), the guys in the pits weren’t your best friend. They weren’t backstopping the markets. Does anyone remember 1987? They weren’t standing in there and saying, “No, no guys. We’ll hold this market up. I want to make sure that there’s never a crash.”

The reality of high-frequency trading is they’re very, very similar to the guys who worked in the pits. It just goes a lot faster. So you have to get a bit better. You have to make the investments, and to that point, you need to be relatively cutting-edge hardware. You need to be co-located. You need to be thinking about your latency. You need to be thinking about how fast you’re changing what you’re doing in the marketplace. If you do something for too long, if you do the same thing every time you execute, they will come find you. There is no question. They are looking for you and they will come find you.

For Crabel, we literally spend tens of millions of dollars on this particular part of our business. I think it’s been a huge differentiator between us and others from our short-term programs to our trend follower. We believe that our execution costs for our trend follower are the lowest or if not around the lowest in the space. If you think about adding back (I mentioned this in the email), if you think about adding back 1% per year to a Sharpe ratio of 0.8 on an 8 vol target or a 10 Vol product, you’re talking about a massive increase when you compound it through time.

So for us, I feel like Crabel is really lucky. Since we operate so heavily in the short term, we have to make the massive investment that is needed for that program to make money. We have to make that investment for that program, and then all the rest of the programs get to ride on the coattails. I know you guys don’t have a lot of like new startups on this program. You mostly talk to people who have been in the business for a bit, who have experience managing money and have made money for clients.

Think about if you’re a startup doing something that’s similar to trend following or of that ilk and now you have to go spend tens of millions of dollars on your execution. Well, good luck. Good luck. It’s really hard to do. I think it’s one of the reasons there’s been consolidation across our space, trend following, etc. The big guys have gotten mostly bigger, with some obvious exceptions. But mostly the money has gone towards the guys who have done this for a bit. I think one of the reasons is that they’re the ones that can afford to do the work. If you’re a startup, who can afford to have a co-location in multiple sites, five sites around the world? Who can afford to do that? It’s expensive, truthfully.

[00:35:02] Niels

This is fascinating. I want to go to another topic that I actually also think is quite fascinating. One of your strategies is in the SocGen CTA Index, and that’s actually how Alan I started thinking about it was to say it’s been a great year for the industry, for the indices, not just the CTA index, but so on and so forth.

But there’s something else going on with the CTA index, the SocGen CTA Index, in particular, and that is that last year, it became evident that one firm that was replicating that particular index saw massive inflows. Of course, the argument was no single manager risk, we just spread it across that. We just look at the returns of the index and then we do some kind of linear regression and we put it into this box and we just need 14 futures markets to replicate the exposure.

We’re always going to be… (well, I don’t think they say always), but we are expected to outperform in the long run, because it’s cheaper. So, a couple of things. One is how does it feel to be replicated? But also, what do you think about replication? And if you have concerns about it (which frankly, that’s what we hear the other guests on this series so far say, it could change). I’d love to hear your thoughts about it.

[00:36:31] Michael

It’s funny just thinking about the details there. Fourteen markets and we do some regressions and let’s go. I think it’s a fool’s errand. I do. I think that this concept that you’re going to be able to get the majority of the returns and then charge low fees, I think that thinking is very problematic.

For me, personally, if I were investing my own money, I’d rather just pick a few managers I think are great and have a good track record of making money and also managing the risk well rather than a replication and pay a little bit of additional fees. What do you get for it? That’s the big question. What are you getting? I think you’re getting actual alpha thoughts, thoughts that are a little bit deeper than what they can pick up in a regression. Everyone likes easy.

Think about America today, by the way. There’s a drug for every problem. You have high blood pressure? I got a drug for you. You have high cholesterol? I got a drug for you. You’re obese? I have a drug for you. I’m not only singling out America, in this case, but it seems to be a theme here, which is like maybe instead of giving you a drug, you should exercise and eat better. Imagine that.

So when I think about this, the replication concept, I’m not saying it’s dumb. It’s fine. I get it. Those guys are trying to make money. It’s fine. I get it. But it seems like a drug answer to a problem. Whereas I think, for those of us who work in this space, short-term, medium-term, long-term, we’re really trying to make the portfolios better. You ask all the competitors. You get to talk to them, right? You can ask them. It’s like, well, is the portfolio the same as it was five years ago? Have you found any new alphas? Are you adapting through time? Are there new pieces of information that might be helpful or not helpful?

I think the truth is that all of us try really hard to get better. We’re all very competitive about being in this business. We all feel very fortunate to work in it too, by the way. It’s a great business to be in. But you have to keep trying to get better. I think that a concept that is just replicating, while it might in an easy year (like I think 2022 kind of was), it’s not surprising that would have pretty good performance. So it’s a good marketing vehicle, they can sell it easily. “We can replicate everything. It’s really cheap. We don’t have to worry about paying these guys. They’re all driving Ferraris because we paid all these fees.” No, no, that’s not true.

We spend 12 hours a day thinking about the markets, managing our risk and understanding new alpha concepts so that we can make our products better for the clients. So I just don’t think you can replicate that type of feeling that most of us have in this space. I’m not saying everyone. Is there a manager out there? I don’t know. But you know, the ones I know, I really like them. They’re hardworking. They care about their clients. They care about making money for their clients and I think that’s really important.

[00:39:26] Niels

Yeah, absolutely. Fair point. Another thing that we debate and maybe this time around, I may have to ask you to wear your more trend following hat than your short-term hat. I don’t know. But we often talk a lot about how many markets should you trade as a trend follower and there are very different thoughts about it.

Some people trade hundreds of markets now, some people stick to the 50, 60 classical, highly liquid markets, etc., etc. I’ve always been on record saying I don’t really see the difference in the numbers. Of course, the performance will be different at times. But in the long run, I don’t see that one or the other group actually performs better as such.

Maybe actually, if I think about it now that I’ve talked to you, I would say maybe the classical, the smaller universe have performed better when I just think about the names in the long run. But be that as it may, I’d love to hear your thoughts about it, what you might gain, what you might lose, other than the obvious, which of course is capacity. I understand why people would want to do it for capacity reasons of course.

[00:40:36] Michael

Well, I’ll tell you. You guys probably know this but I’m the one that designed our program called Advanced Trend, Crabel Advanced Trend. So I have some very specific thoughts about this. Yeah, I think you’re right. Overall, in the long history, maybe they’ll break even against each other, it’s true. I will tell you, one thing that we sort of think is that you never know where the alpha is going to come from.

So one of my thoughts when I designed the program was that if I could get the diversification, I would go ahead and take it. It’s always these things where it’s like, “Well, Michael, do you think it’s going to add 5% per year?” It’s like, “Come on, man. No, it’s definitely not.” First of all, there is a lot of cross-correlation between these markets. Let’s talk about that for a second.

We do trade hundreds of markets, as you mentioned, in ours. We do try to get a flat-ish allocation to the four major sectors. I think you’re right. Sometimes you’re going to have a year where, if you have Bitcoin futures and you’re a trend follower, you’re going outperform because Bitcoin has been interesting for trend following for a bit, both on the upside and now downside. So yeah, sometimes there’s going to be that differentiation between the two.

When I really step back and look at it, obviously you know I chose diversification. But if you’re asking me what’s more important, execution costs or diversification, I’m probably going to go execution costs. So, that tells you my level of feeling about it. I love trading all the markets. I think you never know, In short term, especially, we tend to think you never know where alpha is going to come from.

A market may be a bad performer for a number of years, and then suddenly, it starts lighting up and you really need to be there. Clients ask us, we lost money in the yen for a number of years and people were like, “Why are you guys trading yen?” Then it was our best market ever the following years. That’s why we keep trading yen.

When you think about nat gas, it was really exciting for many, many years for all of us, and then got kind of boring. It really got kind of boring for everybody, right? It kind of settled down there. It did nothing for two years or something like that and then suddenly was exciting again, and guess what? It created interesting opportunities for all of our strategies. So I think we tend to be a little bit more… I guess, if I was going to make a mistake, I’d go with more diversification. I’d rather make that mistake than the one where I’m missing out on interesting new markets or whatever.

[00:42:54] Niels

Yeah. That’s fair. Actually, I want to stay on the topic of markets even if I’m jumping a little bit ahead, Alan, but I think you know exactly why I’m doing it. That’s another theme that kind of has gone through our industry and I think personally, it’s a really difficult one to answer, but it does relate to markets and that’s ESG. Because a lot of people have to have an opinion, and they have to follow certain rules when it comes to ESG. But CTAs, does it really apply to us?

Again, I’ve been on record for this so I can certainly repeat that. I have had my concerns, to be frank, when it comes to say Chinese markets. I don’t even know if you guys trade China so just keep that in mind. But certainly, a few years ago, a lot of these Chinese markets did really well. So there was a return dispersion and you had to kind of justify if you didn’t trade them, and so on and so forth. But at the same time, I did notice that a lot of these bigger firms were talking about ESG and all the compliance and everything they do.

I was thinking, “Well, if you trade China, does it really fit into this ESG thesis?” I don’t want to put you in a corner or anything like that. I had no idea. But I’m just curious because I find it to be a difficult topic when it comes up.

[00:44:16] Michael

Gosh, what an interesting few years it has been with ESG. I find it a little bit fascinating. I can tell you something, I obviously answer these questions for clients all the time. One thing I want to say is I think we should start with separating ESG into two different categories. The product construction, you obviously know that it’s going to be like if you’re a long-short equity guy, this is going to matter a lot more because you have individual names. But I did want to separate it out.

Think about what your firm does, in terms of ESG, I think we really as a firm, we very much focus on it. We have a committee. We really do think about all the pieces of ESG and how to be a great firm for our world, and I think that’s important. Going on to our trading, and this is the question you’re really asking, I give this following example.

So let’s say we decide that high prices for food are bad, because it’s bad for people, right? So, that means that when we buy corn, that’s bad for people. So it’s like, okay, you can’t buy corn anymore. You can only short corn. We’re neutral to all of our markets. Like almost all CTAs, we’re neutral to the market. So, you can only short corn. The farmers, by the way, lose. If you’re shorting corn, you’re hoping it’s going to go down, the farmers are part of it too. So in my mind, it’s a little bit tricky to say that you can’t buy corn, you can only sell corn, because there’s the other part of the supply chain.

And then you say, “Okay, well, Michael, no, no, no, forget it. Crude oil is dirty. You can’t trade that anymore.” Well, let’s start that over again because making a market efficient helps all the participants, including the people that are trying to help the economy that are pro-ESG. If there’s no market need, and again, going back to the corn example, you have Kellogg’s buying you, you have your consumers, you’ve got the producers, you have the farmers, there are lots of people. So for us to be involved as CTAs, creating a market, given that we’re neutral to the market, I’m not sure you can say- we’re not pro dirty, we’re not con dirty, but we helped create a marketplace that allows people to come in and trade those instruments even if they want to be expressing a concept like we want to have a clean world.

I think that’s important. It’s like a small idiosyncratic fact where it’s like you can’t just put a market into a category and call it bad. I think you have to think about what are our roles in all of this? What is our part of the participation?

[00:46:50] Niels

I very much agree, Michael. It’s interesting. We were talking about it as well, of course, not with every single manager because sometimes we have to skip a topic, but we actually brought it up with Harold at Transtrend, the other day. I thought his comments were quite constructive because he, like you, kind of just said you have to remember our role is we’re carrying risk or we’re warehousing risk for people. I can’t remember his exact words.

That is a role, which is kind of neutral in some ways but is super important for the marketplace as a whole, and I kind of like that. Whether it’s going to fly with investors or not, I have no idea. But I like this and I think it’s important to talk about it so we all better understand how to address it. But anyways, I appreciate the thought.

Alan, back to you.

[00:47:43] Alan

Michael, at the outset, you were talking about Victor Niederhoffer, and then the missing piece, risk management (I guess), and the importance of staying alive and living to fight another day. So a couple of things. One, maybe give us a sense of what the processes are. What are the key metrics that you think about in terms of managing risk? Is it gross exposures or are you targeting a certain level of volatility?

Secondly, drawdown, and drawdown management. The short-term space, like trend, have had periods that have been tough like 2011 to 2013. You know, 2016, 2017 was a very low vol environment. So, you can have a macro environment that’s difficult. But equally, I guess the strategies themselves are subject to decay. What are the strategies around drawdown control? Is it around deleveraging? Obviously, it’s intensive research to unearth what’s happening. When strategies go into a tough period like that, how do you think about addressing that?

[00:48:44] Michael

It’s a great question. One thing I think that is true, just speaking for Crabel here, we’ve gotten a lot better at thinking about it. Back in the older days, the alpha was a little easier. These days, with more markets and maybe non-normal distribution of returns, which I think is interesting versus skewy returns ( I think that’s also interesting from a risk management perspective), but we use multiple levels (as a short answer to this question). We do vol target, as you pointed out. Most CTAs do, at some level, vol target. We do allow some flexibility.

For instance, we basically set the portfolio, given our expectation of the strategy’s long-term standard deviation, and then let them go, and then we hopefully, over the long run, hit the vol target. There are a couple of things that we do maybe a little differently than others. We do also use what I would think of as a high-frequency value at-risk model. This value-at-risk model is a covariance-based matrix, it’s updating instantaneously.

So you can imagine, you have some positions on and then a lot of vol comes into the marketplace. Even if you didn’t trade anymore, your portfolio would be seen as more volatile, and we control our portfolios at that distinct level at all times. Now, the truth is we allow our intraday, basically instantaneous expected vol, to move much higher than our average target because some days are going to be lower than target, some days are going to be higher than target, today is a little bit higher than the target. That’s going to happen through time given the opportunity set.

However, we do still truncate the top end of our vol target. So if we have a vol target of 8 to 10 for our shorter-term products, we’ll allow them to go up to about 20, and then at that point, we’re saying, “You know what? We have enough of the risk on.” We’ve done a lot of analysis of this, we have a long history, obviously of trading. We know a lot about what kinds of returns you should expect. If you think about I’m going to add one more position when I’m at 20 vol, instantaneous vol, is that a valuable add? The short answer is that you do get deterioration of your risk-adjusted return at the top end.

So given that we know that, we’ve geared our portfolio to express the risk in a certain way and deliver return. One thing that is part of the design of our trend follower Advanced Trend, is that we have a belief and, in the end, it comes back to us being a little bit shorter-term thinking.

But here’s a belief that we have. We believe that sometimes Sharpe ratio of trend following is going to be high, think 2 plus (like last year), and sometimes it might be low, maybe even negative. So, in our trend follower, one way that we gear the portfolio is we allow its target volatility to fluctuate up when (obviously systematic, automated, etc., we’re not touching this), but when our alpha signals believe that this is a little bit stronger trend (up toward the 2 end), when it believes that that’s the case, it wants to have a little more vol on. So we actually allow the vol target to move and I think we’re one of the few that do this.

There are a lot of people who don’t vol target at all. And yeah, look, we can find them. They were up 70% last year. Got it. Understood. But for those of us who target, in our case 15 vol for advanced trend, we actually allow it to fluctuate based on the alpha availability. This has helped us, in a few instances, outperform our peers because we’re allowing that flexibility, given the alpha concept behind it really believes it’s a high Sharpe environment.

[00:50:38] Alan

What about the drawdown control? When the space goes into a tough period and your own strategies, some managers will have thresholds where they de-lever the portfolio. Do you believe in that or not? Secondly, will you retire certain strategies? Is that just purely based on a stop-loss type or max drawdown type of approach? I suppose, how do you manage the question of whether something is broken or just you’re drawing out of the negative side of the tail?

[00:53:01] Michael

I think that last one is a really fun question and I haven’t answered that. Just on the drawdown side, we do tend to down-lever a bit as we go into a drawdown. It’s systematic and it is a part of the program. We do believe that there can be periods of time for the shorter-term programs where the alphas aren’t as available, then all you have is trading costs. So if you have no alpha and a bunch of trading costs, you’re going to get a negative return stream. So yeah, we do tend to manage that. But we want to be very dynamic and adaptive. So, the short answer to your question is yes, we will bring the leverage down as we go into a drawdown.

Actually, if there are interesting situations in the marketplace where if the portfolio says, “No, no, this is really good,” even in a drawdown, we will get the vol. It will come. The second question for our trend follower, for Advanced Trend, we tend not to be as aggressive. We understand what that Sharpe ratio is, we understand its role in our portfolios.

We have trend in all of the portfolios that we run. We do think it’s a really interesting and great diversifying return stream on a standalone basis, but also for our program (just to put it in perspective). We don’t do as much with that one. We tend to let it be. We understand what are the long-term benefits to that and what are the long-term drawdowns to that and we are willing to accept them.

The question about retiring strategies is a really interesting one to us. We are a firm with tens of thousands of strategies as it turns out, so it’s really fun. Some have been making money forever, some are brand new, so it’s a really fun and interesting question. We tend to think about it in a couple of different ways. Imagine a strategy that’s made money for 10 straight years (so alpha concept), and then it gets Trump night wrong – it has a huge drawdown. So, you have a perfectly up and right return stream (realized return stream), and then it gets Brexit wrong, and then boom, it has a steep drawdown.

You might look at that and say, “Oh my gosh, you just wiped out the last three years of returns. It had such a good Sharpe but now these rolling one-year, two-year, three-year Sharpes are all negative.” I think sometimes a strategy like that can have a lot of scrutiny, but I will tell you the truth, we tend not to touch them. We tend not to down-allocate them, we tend to leave them just as they are. Because getting unlucky (and I recognize that is a tricky statement I just said there), but getting unlucky is not ‘alpha is dead.’

So for us, we would differentiate between a strategy that has a really nice, solid strong track record and had even a very, very steep loss, against the following kind – a strategy that has been making money and then it just starts rolling and suddenly, you’re one year flat, two years flat, slightly negative, three years, four years. If you think about the shape of that, for us, we would believe a lot more that has an alpha deterioration factor that we don’t understand and probably (number one) that strategy would definitely get down allocated.

I will tell you, we tend to be strategy collectors, not strategy destroyers because you never know when a concept might want to pop back up again or you found an improvement that deals with that deterioration. But that one tends to be a little more eye-opening to us. It’s distinctly on our list of things that we look at. I just want to add one thing. The caveat to that is the following (and you mentioned 2016-17 low vol period just a second ago), I want to point out something.

When you are doing almost any type of trading, managed futures all struggled during that period. There just wasn’t much action. So the question is, if you’re in a market environment where you expect that strategy to struggle a little bit, and you have a flattening like that (which was kind of a long flattening, frankly, a year or so, a little bit longer than a year maybe), I think you have to accept that as part of the program.

Now, you may want to design strategies that make money in that situation. Fine. Good idea. But I think you have to be a little bit careful, if you have a strategy that’s leveling off in terms of alpha, in an environment that you would know is the weakness of that environment. If you’re not happy with the overall portfolio performance, well, then, goodness gracious, go back to the research department. Because, yeah, okay, I get it. Sure. But the reality is that we will be a little bit circumspect when we have a strategy underperform in a market environment where we don’t expect it to perform well.

So we have to be very careful about leveling off of alphas. Even if you think about May 2020 through all of 2021, it was about 18 months of falling vol. Now, VIX didn’t fall so people don’t talk about it as much, but on a realized basis, it was a pretty boring period. Bonds stopped moving, yen stopped moving, Euro stopped moving. Everyone thinks, “Oh, didn’t NASDAQ move in 2021?” Yeah, NASDAQ. Go look at Russell. Russell was flat. Go look at the Nikkei, flat. Go look at the Euro stocks, flat. Okay.

Suddenly, when you think about 2021 or that pretty long period of time, and you’re like, “Oh, trend following didn’t do so well, maybe I should get rid of the portfolio.” Some people made that decision and they missed 2022.I think when you think about a strategy or an overall portfolio, you really have to think about what are you geared to make money in and what happens when you don’t have that environment.

Should you be so upset? Should we be yelling and screaming in our office, “Make it Better! Make it better?” Or should we be a little bit circumspect about what we do for a living here, what our jobs are? Because if you were to get rid of all the strategies that underperformed during a pretty dull period of time, that was 18 months long in 2020 and 2021, well, you wouldn’t have been around for 2022. So I think it’s really important, anyway. It’s a long answer to a short question but we tend to be circumspect about it, the short answer.

[00:58:42] Niels

Now, I want to talk about three things that kind of go together to some extent. It’s interesting because you are a little bit different than many other of our peers. I’m talking about capacity fees and flows, because in my mind, you were actually one of few firms that in the last couple of years, in a sense, you came up towards your capacity in some of the shorter-term strategies, while trend followers (the way I recall it) probably had a little bit of a capacity issue after ’08 because a lot of people came into the strategy.

Maybe that was the reason why we, as an industry, didn’t do so well, although it’s certainly not entirely that reason. Then people redeemed from trend following and there was suddenly a lot of capacity released. So, we came up with this brilliant idea as an industry to say we should just offer trend following incredibly cheap.

So we had a lot of money, not a lot of money, but over time, a lot of money came back, especially from some big pension funds where they could get some really good deals. You, of course, have a flat fee (as I recall it), for the trend side. But what I’m hearing in my conversations offline is that some managers are now starting to think about, “Well, clearly there’s demand. Clearly, we’ve made money, we have more AUM now.

Perhaps we don’t like the fact that we have so much of our AUM, certainly in the trend space, tied up in very low fee paying mandates. So, we’re going give back some of that to the clients so we can replace it with higher fee money.” How do you think about capacity fees? And this is my hope, I guess, could we even enter a period where fees might go up again and we don’t have to defend fees as much as we’ve had to? What are your thoughts?

[01:00:41] Michael

It’s an interesting question, a great question. I think a couple a couple of things. I’ve made peace with the fact that the fees have come down. I coined a little term for us internally at Crabel. I call it the mutual-fundization of the fees in hedge funds. Because the reality is if you think back 20 years ago, to get an S&P replicator, you were going to pay 1% per year. You were going to pay a broker and maybe even more than that. I mean, goodness gracious, and now you pay two basis points.

Well, the truth is that the fees, to do simple things, have come down to rock bottom when it comes to mutual funds. The things that are harder to do, that are more expensive, think emerging market debt, you better have some good researchers on that. Think about emerging market debt, it’s trickier. They charge higher fees. My thought about hedge funds is that the fees will continue to come down for the simplest concepts. Things that are the most easily found will end up with lower fees. I think that’s just a reality about that.

Now, the cool thing about our space, and think about all the great players out there in our space, I think that our ability to innovate and do things that are different and interesting, the more we’re able to do that (and I don’t even want to name a bunch of my competitors, but they’re doing it too), the more we’re able to do that, the more you can charge a premium for your services.

So to your question there if you’re asking me, what’s the overall hedge fund fee going to do? I think it’s going to keep going down. Then if you ask me the question, what are the best alpha shops? What’s going to happen to their fees? I think the answer is up. I think about it from Crabel’s perspective. Do I think there’s a world in which we’re going to redeem people and only accept new high fees? No, I just don’t see it for us.

We really love the clients that support us. We have the business, a lot because of them and that’s an important partnership and relationship. So no, I don’t see us trying to return money and taking on more higher fee money. Obviously, you can not discount or maybe raise fees as you go forward as you maybe get redemptions. And that I think it’s fine. But it’s not something that we’re really looking to do.

We’re really happy with clients we have. We’re happy with the products we’re able to produce and maintain. If you think about all the most successful hedge funds in general, the ones that have been able to charge the most fees(think Renaissance Technologies just for a second), they got to raise their fees, raise their fees, raise their fees, and kick everyone out. Okay, good for them. I’m not sure our space is ever going to see something like what they did again. It’s miraculous when I look at them, but the truth is that the more alpha you can provide, the more interesting return stream that you can create, the more likely you will be able to charge a little bit of a premium based on what the industry is doing.

[01:03:43] Niels

Yeah. I think that’s fair. Our final question on this topic was the thing about flows. I think a lot of people might believe that when you have a great year for our industry, a lot of money will flow into it. That may still be the case but so far, that’s not my observation at least. I think that perhaps it might even be the other the way around. As we know, from 2008 a lot of people used CTAs as an ATM.

Maybe there’s a little bit of that this time around, although for different reasons, I think there’s probably more rebalancing than it was really managing crises. Who knows? What’s your observation about flows? But also, do you have any expectations about flows as we head into the new year?

[01:04:30] Michael

Yeah, that’s great question.

[01:04:31] Niels

For the industry. It doesn’t have to be specifically to you, but just kind of generally speaking as well.

[01:04:35] Michael

I think you nailed it there, Niels, first of all. Let me just point out, I think you nailed it. We did see outflows despite good performance in the last six months of 2022. It was at first surprising and then the more we talked to clients, it wasn’t like, “Oh, Michael, we hate you. We’re redeeming.” It was like, “Michael our stocks are down 30, our bonds are down 15, and now we have an imbalanced portfolio because our mandate is 10% alternatives?”

By the way, in alternatives, we got a bunch of private equity and private debt and infrastructure. What happened to those last year? I don’t know. They didn’t go down despite the fact that they should have. So the thing that made money, alternatives, futures, yeah, we all made money. That’s great. But now, where do they take the money away from? It’s like people forget about the 2008 situation, which is like if pension funds need to rebalance their portfolios, which I think they absolutely have to right now, where is the money coming from? Well, it’s not coming from private equity.

I made a prediction for our firm that we would see continued outflows into the end of 2022. There is that other side, which you also mentioned, which is something like what’s the lag between good performance and people being able to onboard a new [investor]. It doesn’t take one day, right? With diligence, it’s something like a 12 to 18-month sales cycle. We do. We think that AUM increases, in this typical case, will be on a bit of a lag.

I do expect inflows for Crabel Capital Management. I expect inflows for the industry. Once all the clients get rebalanced, and then we see okay, this is the advantage of being in managed futures, this is what CTAs are good at. Hopefully, for those who have either stepped away from the space, think CalPERS, they stepped away from the space a few years ago, maybe they see that benefit again. Maybe they said, “Okay, you know what? Let’s rethink this. Let’s make sure we have a balanced portfolio. Let’s make sure we have strategies like this and it’s not just all private equity.” I think that you will see the flows in.

So my general statement is 2023 is an inflow year, even if you still have a few of the pension funds who are on different fiscals that still need to rebalance the portfolio. And hey, that’s part of being in the business. It’s okay. When they call you up and tell you they’re rebalancing because they need to put more money in stocks and bonds because that makes their portfolio balance right and they’re hitting their target allocation, how can you be mad? You know what? They’re saying thank you, and you’re proud that you made them money.

Oftentimes, you’re talking about a Teacher’s Retirement System of name the state. You know how proud it makes me feel to make money for the teachers? Very. It’s so cool. What a great thing. So you can’t get too mad at that. You just have to roll with it. Be prepared. So I’m excited for the future to say it out loud.

[01:07:21] Niels

Yeah. Absolutely.

Alan, your last round of questions before I wrap up?

[01:07:25] Alan

Yeah. You’re talking about the allocator perspective, how they’re looking at their portfolios now, which brings up the point about where did the different portfolios programs you run, where they fit the role that they play in a multi-asset portfolio and asset allocation plan? What are your thoughts on that in the sense, obviously, they’re presumably in the absolute return buckets? Often, a lot of these allocators have buckets.

You’re not just competing against the other short-term manager up the street, you’re competing against all manner of different hedge fund strategies and privates, all of this stuff. But to be more specific, would you see (with your multi-strat, multi-product product), would you see that just as an absolute return product or is it a portfolio protection? And then is it a return generator or a diversifier or both? When you’re positioning those products in front of an asset allocator like that, what’s the positioning?

[01:08:29] Michael

I think we do see that as absolute returns for all of our major products. They are absolute return oriented. That’s the way we think about them. Per your point there, a lot of times people do think about us and a number of other clients do think about this, and they put us in this crisis risk offset style bucket. You know what? I get it.

We don’t necessarily design it exactly for that concept. We design for alphas. Let’s make money. First and foremost, you have to make money. But I think that as it turns out, the return stream lends itself well and I think circling back on it, I do think it is important to think about that balanced portfolio.

In fact, I was having dinner in December with a competitor, a large competitor. I don’t feel like, “Oh, my gosh. They’re going to win all the money or we are.” I just don’t feel that way. I really like to be friends with the competitors. I do like the majority of them, all of them in our space. Most of us are trying really hard to do well for the clients. When we all do well, the clients do well, our space does better. There will be assets for us all. It’s fine.

I sat down at dinner and I asked him, I said, “Hey,” his name happens in Michael as well. I said, “Michael, what would you do with your life if you weren’t doing this?” And he said, “You know what? I’d want to work at a pension fund so that I could really help create great portfolios that are diversified thoughtfully, not just for liquidity reasons, but also for return purposes because you could help that state or you could help the teachers.”

I thought that was a wonderful answer, a great answer to that question, because oftentimes, Alan, circling back on this question, it gets confusing. Like, hey, you have to answer to a board when stocks are up 37% and your bond portfolio is up 10? That’s hard to answer when your trend followers are flat, when your diversifiers didn’t have a lot of alpha that year. I get it.

It’s like line item, by line item, by line item, it takes balls of steel to sit there and see a negative return year when the portfolio is making 30 plus percent. But you know what? You have to be able to be circumspect about it and think to the future, and I think when we think about it, yes. Do I happen to believe that there’s some crisis risk offset, like we talked about earlier, being a little bit long vol? It’s helpful. It’s helpful. It’s not perfect, but it’s helpful.

[01:10:52] Alan

The other thing is like sometimes people think short-term traders, they are long vol, they have that long vol characteristic more so than trend. So then does that put you into being compared against tail risk, volatility traders? Do you fall into that bucket a little bit more or do you dissuade allocators from thinking about it in those terms?

[01:11:18] Michael

Dissuade is the short answer. I think generally speaking though, I think people really do think of us… If you brought 10 of our largest clients on here, I’m going to tell you that they all think of us as a diversifier. They don’t spend a lot of time thinking about us as being in some other tail hedgy sort of space.

But again, I think the return stream itself lends itself to at least helping in that case, and I think that’s helpful for them. But no, I think squarely, even though short-term futures are a little bit idiosyncratic in the CTA space, I still think we kind of get lumped in. So, when trend follower is doing well, sometimes people even ask us.

Maybe one year trend does well and short-term doesn’t do so well, they’ll say, “Didn’t futures do really well this year?” And you’re like, “Well, yeah. Trend following did well,” that’s why you have a diversified portfolio, by the way, “but short-term futures didn’t get quite the opportunity set that trend following did. That happens. That’s why there are multiple zero-correlated trends. That’s why they’re a good complement to each other. Gemini.

[01:12:18] Alan

Just one final one from me. I realize we’ve gone a bit over on time. But as you’re a short-term manager, I think this one is important around liquidity. We always hear in markets, concerns about liquidity. You see some crazy moves, and everybody says, “Oh, my God, the liquidity market isn’t what it used to be.”

You talked about the basis risks in treasuries in March 2020. There’s an ongoing discussion going on and mystery around that. Even earlier this year, we had crazy moves in sterling and then in the gilt markets. They seemed crazy at the time, but obviously, we’ve seen these kinds of moves in the past. So what’s your perspective? As a participant who’s very close to the liquidity, is it better or worse, any different to what it’s been historically?

[01:13:04] Michael

I think it’s important how we frame this, and I’ll tell you why. The headlines are all exactly what you’re saying. The headlines are, “Liquidity is shit. Markets have become less and less liquid. What’s going on? All the market makers are backing away. The participants are leaving. The banks no longer have the prop desks. They’re also not in their making markets.” Yeah, I hear it, I hear it, I hear it.

There was actually a piece put out by JP Morgan literally like two weeks ago or a week ago or something like that saying that this is historically one of the lowest liquidity periods for S&P futures that we’ve seen, and they showed some pretty charts. Yeah, I get it. I get it. I hear you.

But let’s start back over again. If you’re talking about pure liquidity and now you’re asking the market makers to stand in, to think about this as a gross notional basis, I’m going to quote the S&P futures by 50 by 50 inside. And now you triple the vol. I could triple the vol. What if I quintuple the vol? You think I can quote 50 by 50 instead of bid ask on the ES futures? No way.

So in my opinion, the popular media generally gets it wrong. Even people that are smart, like JP Morgan, they get it wrong, because they don’t vol adjust. If you vol adjust the book and look at it through time, there might be a small decline in the liquidity. But in truth, we trade tens of millions of futures contracts. We’re the largest futures traders in the world because we have high assets and we have short-term trading, which turns over a lot. So we trade a lot and the way you would see low liquidity is you would see high slippage.

Well, for us, for Crabel Capital Management, 2022 was our lowest slippage year ever. Well, how’d that happen? Are we just that good at it? Well, yeah, sure. I think we’re pretty good at it. But are we just not good at it? No. The truth is that there was a lot of volatility and the volatility-adjusted liquidity was there for us. Now, look, I do want to point something out. If you go to 2020, you go to March, I think it was the craziest thing I’d ever seen. Having seen ’08, the markets were pretty tight in a’08. Now, they were less liquid, obviously.

But I would say that if you look at NASDAQ in 2008, you would have seen a light book. But it was still pretty tight, fast-moving, but it was ‘08, it was a long time ago. Fast forward to 2020, not only was the book light, but I actually thought the spreads we saw four points (not one tick, not four ticks, four points) wide on S&P, four points wide on NASDAQ. I thought that was the most unusual thing I had seen in the marketplace.

Do I think that adaptation by the market makers (high-frequency traders), do I think that’s an adaptation by the market makers to the modern world and an adjustment to the volatility we were seeing in March 2020 which was incredible, as we all know? Yes. Do you have to live with that environment? Yes. So, I guess what I’m saying is, to the popular media out there, and to people who just want to complain about it, fine. Even the JP Morgan guys (if they’re listening to this and they hear me), do that study over again but volatility adjust it and you’ll find out that there’s just as much volatility.

So if you’re trying to get one standard deviation of ES on, you can get the same amount of standard deviation than you’ve ever been able to get. So let’s start over with that discussion.

[01:16:24] Niels

Good points.

Now, the final question will actually be two questions, because you again have two hats. You have a short-term hat and you have a trend following hat. You also promised before (I don’t know if you promised), but before we pressed record, you said, “I can be very controversial.” So here’s your chance, Michael, because I don’t think you’ve been that controversial yet. But I wanted to ask you. So it’s a two-part question. What is the one thing you hear about short-term trading or the one thing you hear about trend following that you disagree with the most?

[01:16:56] Michael

One thing I would say that I disagree with wholeheartedly, and this view has been around for a while and it really bothers me, which is that we’ve been in meetings maybe with prospective clients, they will say, “We can’t trust you and your return stream because out of sampling, we don’t know what’s going to happen. You guys make changes all the time. You need to be a set-it-and-forget-it shop like this other shop over here.” I really feel like that’s a misunderstanding of the alphas and ability to extract anomalies from the marketplace fundamentally.

When I hear someone say that, this, in particular, was related to trend following. This comes up like every year or something like that, not one time, where it’s like, “Trend follower XYZ just sets it and forgets it and they make money forever. I can trust them. I can’t trust you guys, because you guys are making changes.” Okay, sure. No problem. Just compete, I’ll take that bet. Let’s go, me against those people, Crabel against those people, we’ll take that bet any day of the week because we do feel like we make improvements.

We are looking for alphas. I talked about our trend follower. We try to expose ourselves a little bit more using alpha concepts to trend, and it’s worked out okay for us. So I think that when I hear that from people, this idea that you can’t improve or because you’re improving your portfolio, I can’t trust the added sample returns. Look at the long history of our firm. Look at the long history of this space. Overall, you want to keep improving.

People who didn’t improve, hey, we were all in business when John Henry was running all the money too, remember that? Well, he didn’t change anything ever. He kept his vol, he let his vol move around a lot, you guys remember. (Who doesn’t love John Henry, by the way?) He shows up at Moneyball, good for him. But also, he kind of gave us a bad name, because he sort of thought like, “Oh, set it, forget it. It’s over. Trend forever.” I don’t think they have a product anymore. I don’t know if they do or don’t, but I certainly don’t hear about them. I like John Henry, he’s clearly a smart guy. So anyway, that’s probably one thing I hear.

The other thing I think, for the short-term space (I’m not sure if it’s controversial or not), but they say, “You guys have a long vol and S&P went down 2.5% yesterday and you lost money.” Sometimes we’ll get clients who really will call us up and ask us about that. And the short answer is it’s path dependent, we are not perfect, you clearly know that. If we were perfect, the fees would be a lot higher or maybe we wouldn’t even be managing client money at all.

So let’s be honest with each other about what we’re doing. Yeah, we have a long vol bet. That’s true. It’s positively skewed. That’s true. But you’re not going to get every single day the market moves down 2.5% right. You may come in with a wrong position going in from the day before. For alpha concepts, especially in the short term, it matters a lot about the path. A market that gyrates a lot, intraday, and then closes up 2.5%, you may not get that day particularly right. It may be a losing day because of the way you control risk on an intraday basis. We control it very carefully.

I think that’s one thing I’d say is, hey, just because we have a long vol profile, doesn’t mean we’re going to get every single day right. But we know, overall, the preponderance of evidence should be in our favor, look at the long track record. So yeah, there’s that too.

[01:20:13] Niels

Okay, that’s fair. That’s fair.

On that note, we’re going to wrap up this fascinating conversation. Michael, thank you so much for being on the podcast and for sharing your thoughts and insights with us. We hope that we can do this again sometime in the future.

To all of you listening today, I hope that you were able to take something from our conversation onto your own investment journey. And if you did, please share these episodes with your friends and colleagues.

From Alan and me, thanks so much for listening. We look forward to being back with you on the next episode of Top Traders Unplugged as we continue our deep dive into the CTA industry. In the meantime, go check out the show notes for this episode and all the other resources you can find on the website. Take care of yourself and take care of each other.

[01:20:54] Ending

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